Understanding Hedge Funds – Are They Worth the Risk?
3 min read
stock market
Hedge funds operate like mutual funds by pooling investor money into strategic investments; however, hedge funds often employ more aggressive and riskier strategies in pursuit of outsized returns, including leveraged short selling and the purchase of assets that mutual funds do not permit their investors to purchase directly.
Hedge funds are only open to accredited investors who possess at least $1 million (excluding their primary residence) in net assets (excluding their primary residence) and the ability to withstand large financial losses.
How Hedge Funds Work
Hedge funds are high-risk investment pools that utilize complex trading and portfolio construction techniques such as leverage trading or short selling. Hedge funds are generally only open to accredited investors, but may offer higher returns than mutual funds with greater risks attached.
Hedge funds seek to capitalize on market environments where other investors are betting on price declines, like an equity bear market. Managers employ long-short strategies that balance out their investments across securities or market sectors – for instance, buying 100 shares of Google while simultaneously shorting 20 Apple shares so as to ensure equal dollar amounts invested (hedging).
To invest in a hedge fund, the minimum investment requirements can range anywhere from $25,000 to over $1 million and beyond. You also must agree to leave your funds with the fund for an agreed-upon amount of time – this period is known as lockup.
Hedge Fund Strategies
Hedge funds employ various strategies and invest in various financial instruments, including stocks, bonds, currencies, derivatives and real estate – often in illiquid markets. While some hedge funds take both long and short positions simultaneously or invest heavily concentrated portfolios with concentrated positions; others focus on specific strategies or invest heavily concentrated positions while using leverage or other forms of risk management such as high frequency trading for risk mitigation.
Hedge funds are private investment partnerships available only to accredited investors. Investors must demonstrate proof of income, assets, debt and experience to qualify as accredited. Furthermore, these investors typically commit their funds for an extended period – typically several years – making hedge funds both more exclusive and risky than mutual funds.
Hedge Fund Fees
Hedge funds typically charge an asset-based management fee of 1-2% of assets and a performance fee of 20% of profits, which can add up to significant fees over time. Critics have long pointed to this compensation structure for encouraging managers to take greater risks in pursuit of higher returns; as a result, recent results for hedge funds have been disappointing.
Hedge fund managers possess the ability to make highly concentrated trades and use leverage to increase gains and losses, creating greater volatility and potentially lower long-term returns compared to mutual funds.
Hedge funds are generally restricted to institutional investors like pensions, insurance companies and wealthy individuals (accredited investors). However, a few ETFs and mutual funds claim to follow hedge fund strategies without needing accreditation; investors should carefully evaluate these alternatives when weighing their options.
Hedge Fund Liquidity
Hedge funds often impose complex liquidity terms that vary based on manager and strategy, designed to avoid potential asset/market liquidity issues as well as protect market integrity during times of stress.
Gates and side pockets gained attention during the 2008 financial crisis as hedge fund managers struggled to meet redemption orders as the assets became difficult to value. Investors should understand and respect these restrictions when considering whether investing in a hedge fund meets their individual investment goals while taking into account potential liquidity restrictions associated with certain funds.
As with any investment, hedge funds carry fees that can significantly eat away at your return. Management fees – usually 1-2% of invested capital – and performance fees paid only when specific targets are achieved can quickly add up, with initial investments typically required between $100,000 to $2 Million for these funds.
